China: Flexing their Muscle

According to the latest data from Treasury, foreign investors were net sellers of U.S. dollars. The Madoff scandal led to a tremendous amount of liquidation by hedge funds in the Caribbean and Luxembourg but we have our eye on China. The Asian Giant continues to be a net buyer of dollar denominated investments, albeit at an increasingly sluggish pace. For the third month in a row, China has slowed their purchase of U.S. dollars. There are many reasons why their demand for dollars is waning, but don’t expect them to become net sellers of U.S. dollars anytime soon ahead of the Treasury’s report on Currency Manipulation next month.

With a month to go before the report is due for release, China is flexing their muscles. This weekend, Chinese Premier Wen Jiabao signaled to the U.S. that they are fully aware of the power they have on the U.S. economy and how the U.S. needs China just as much as China needs the U.S. He said that “we lent such huge funds to the United States, and of course we’re concerned about the security of our assets.” If China decided that U.S. investments are no longer safe, their liquidation would drive yields significantly higher and stocks significantly lower. The consequences of infuriating China are severe because they have the power to retaliate.

China’s continual accumulation of U.S. Treasuries is also political. With a growing U.S. deficit, there are much better ways for China to spend their money such as investing in resource companies. The sharp decline in Chinese exports also automatically reduce their need to weaken the Yuan by buying U.S. dollars. However for political reasons, the Feb and March TIC data should continue to report that China is a net buyer of U.S. dollars.